The Best Trades for QE3

by Lawrence Meyers | September 7, 2012 10:50 am

The Best Trades for QE3

The Fed certainly seems to be preparing for a new round of quantitative easing, perhaps especially now that the August employment report showed another step backward on the critical jobs front[1]. Although the benefits of the central bank’s previous two easings, as well as “Operation Twist,” remain unclear, the Fed apparently feels that it can’t just sit back and let the economy do its thing without intervention.

So, all you can do as an investor is figure out how to take advantage of this likely move. Here are three areas worth considering for the coming QE3.

Gold

QE1 ran from November 2008 to March 2010, and during that time gold climbed from $760 to about $1,100. QE2 ran from November 2010 to June 2011, and during that time gold rose from $1,360 to about $1,560.

The correlation between the easing, which increases the Fed’s balance sheet, and the price of gold is pretty striking. Gold’s rise during QE2 wasn’t as dramatic, likely due to the fact that the world was panicking when QE1 started and buying gold regardless of what the Fed was doing.

Still, it’s probably a decent trade to go long gold and expect a 10%-15% return, and possibly more. But trading gold is a dicey game, and you’d better have tight stops set. I’d buy SPDR Gold Shares (NYSE:GLD[2]) for its liquidity.

Fixed Income

Quantitative easing is supposed to drive interest rates lower and thereby encourage borrowing. When the Fed uses its own money to purchase its own bonds, that demand drives bond prices up and yields go down. The actual effect of the easing on interest rates isn’t terribly dramatic, but it has certainly kept them low.

Consequently, bonds that are supposed to offer fixed income are barely paying anything. People are beginning to seek yield elsewhere, moving into safer dividend-paying stocks and things like preferred stocks[3].

Thus, you should probably hold onto consumer staples that pay dividends, like 3M (NYSE:MMM[4]) and McDonald’s (NYSE:MCD[5]) and assume they’ll have a price floor, which I think they will. You could also buy the SPDR Consumer Staples Sector Fund (NYSE:XLP[6]) for diversification.

On the preferred side, I think we’re at the beginning of a big secular move as people realize the relative safety of these securities. The SPDR Wells Fargo Preferred Stock Fund (NYSE:PSK[7]) yields 6.15%.

Commodities (and the Dollar)

The dollar’s value was forced down during the Fed’s previous easings. Consequently, the value of commodities rose because they’re inversely correlated to the dollar. The CRB Index went from about 215 to 275 during QE1, and from about 300 to 330 during QE2. Consequently, we might expect the same kind of increase.

It’s difficult to play commodities as a whole, only limited ETFs are available and each has a downside. My choice would be the DJP-iPath Dow Jones-UBS Commodity Index ETN (NYSE:DJP[8]).

Part of the commodity group includes energy. Now, I’m big on holding energy anyway for the long term. So I’m not shy about owning one of the big producers like Exxon Mobil (NYSE:XOM[9]) or Chevron (NYSE:CVX[10]). Alternatively, you can own the United States Oil Fund (NYSE:USO[11]) to have direct exposure, but it’s mighty volatile!

It’s important to remember that these are all essentially medium-term trades. In a diversified portfolio, I would suggest allocating small percentages to each of these categories anyway. This simply gives you an opportunity to perhaps turbocharge your returns.